What is a Dividend?
A dividend is the share of profits and retained earnings a company pays out to its shareholders. When a company generates a profit and accumulates retained earnings, those earnings can be either reinvested in the business or paid out to shareholders as a dividend. The annual dividend per share divided by the share price is the dividend yield.
How a dividend works
A dividend’s value is determined on a per-share basis and is to be paid equally to all shareholders of the same class (common, preferred, etc.). The payment must be approved by the Board of Directors.
When a dividend is declared, it will then be paid on a certain date, known as the payable date.
Steps of how it works:
- The company generates profits and retained earnings
- The management team decides some excess profits should be paid out to shareholders (instead of being reinvested)
- The board approves the planned dividend
- The company announces the dividend (the value per share, the date it will be paid, the record date, etc.)
- The dividend is paid to shareholders
Below is an example from General Electric (GE)’s 2017 financial statements. As you can see in the screenshot, GE declared a dividend per common share or $0.84 in 2017, $0.93 in 2016, and $0.92 in 2015.
This figure can be compared to Earnings per Share (EPS) from continuing operations and Net Earnings for the same time periods.
Types of dividends
There are various types of dividends a company can pay to its shareholders. Below is a list and a brief description of the most common types that shareholders receive.
- Cash – this is the payment of actual cash from the company directly to the shareholders and is the most common type of payment. The payment is usually made electronically (wire transfer), but may also be paid by check or cash.
- Stock – stock dividends are paid out to shareholders by issuing new shares in the company. These are paid out pro-rata, based on the number of shares the investor owns.
- Assets – a company is not limited to paying distributions to its shareholders in the form of cash or shares. A company may also pay out other assets such as investment securities, physical assets, real estate, and others.
- Special – a special dividend is one that’s paid outside of a company’s regular policy (i.e., quarterly, annual, etc.). It is usually the result of an excess cash build up.
- Common – this refers to the class of shareholders (i.e., common shareholders), not what’s actually being received as payment.
- Preferred – this also refers to the class of shareholders receiving the payment.
- Other – other, less common, types of financial assets can be paid out such as options, warrants, shares in a new spin-out company, etc.
Dividend vs buyback
Managers of corporations have several types of distributions they can make to the shareholders. The two most common types are dividends and share buybacks. A share buyback is when a company uses cash on the balance sheet to repurchase shares in the open market. This has two effects.
(1) it returns cash to shareholders
(2) it reduces the number of shares outstanding.
The reason to perform share buybacks as an alternative means of returning capital to shareholders is that it can help boost a company’s EPS. By reducing the number of shares outstanding, the denominator in EPS (net earnings/shares outstanding) is reduced and thus EPS increases. Managers of corporations are frequently evaluated on their ability to grow earnings per share, so they may be incentivized to use this strategy.
Impact of a dividend on valuation
When a company pays a dividend, it has no impact on the Enterprise Value of the business. However, it does lower the Equity Value of the business by the value of the dividend that’s paid out.
Dividends in financial modeling
In financial modeling, it’s important to have a solid understanding of how a dividend payment impacts a company’s balance sheet, income statement, and cash flow statement. In CFI’s financial modeling course, you’ll learn how to link the statements together so that any dividends paid flow through all the appropriate accounts.
A well laid out financial model will typically have an assumptions section where any return of capital decisions are contained. For example, if a company is going to pay a cash dividend in 2021 there will be an assumption about what the dollar value will be, which will flow out of retained earnings and through the cash flow statement (investing activities), which will also reduce the cash balance.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, these additional resources will be useful: